What is discounted cash flow and why is it important

What is discounted cash flow
by Meredith Galante, posted in Finances

Real estate investors buy properties that they hope in the future will earn them a considerable return.

To truly understand what that value is, investors can use discounted cash flow to estimate the value of that home in the future, with future cash flows in mind, during the time period they own it.

What is discounted cash flow analysis?

Discounted cash flow is a metric used by investors to determine the future value of an investment based on its future cash flows.

For example, if an investor buys a house today, in 10 years, they hope it will sell for more than what it is worth today. But that’s not the only income — or expense — generated by the property. If the home is utilized as a rental property, cash comes in. If the investor plans a renovation, money goes out. All of this is cash flow. It helps determine the future value of a home for an investor. The discounted cash flow helps investors figure out what that future value of the cash flow is.

Discounted cash flow helps investors evaluate how much money goes into the investment, the timing of when that money is spent, how much money the investment generates, and when the investor can access the funds from the investment.

The formula will take into account Initial cost, annual cost, estimated income, and any necessary holding period.

How do you calculate discounted cash flow?

Investors can use a basic formula to calculate the discounted cash flow model. Before getting started on your DCF analysis, have the initial cost of the property, any interest rates, the year-by-year expenses and profits, and any holding periods laid out. The holding period is how long you plan to own the investment, which for most, is typically between five to 15 years.

Then, you can use the following formula:

DCF = CF1 / (1 + r) 1 + CF2 / (1 + r) 2 + … + CFN / (1 + r)N

DCF = Discounted Cashflow

CF = Cash Flow

r = discounted rate

Each subsection of the formula allows investors to evaluate their cashflow by a particular year to see how much money is coming in. The subsection repeats for however many years you estimate you’ll own the investment property.

An investor can determine a property’s cash flow by calculating the following:

  • Initial investment: Cost of purchasing the property
  • Income: rental income, payments from vacation rentals
  • Expenses: mortgage payments, utilities, upkeep, cost of debt
  • Estimated sales proceed the year the property is sold

For new investors, the formula can seem like a foreign language, but users can use Excel to determine the discounted cash flow. Excel classifies this as =NPV.

When do you use discounted cash flow?

Real estate investors use discounted cash flow when trying to determine a low-risk investment’s value in the future when they’d want to cash out. In the investment banking world, companies can use the discounted cash flow formula to know if the value of a business is a good long-term investment, as well. A DCF analysis also helps investors know if the investment is a fair value or the true value of a company.

It’s important to note that investors will use estimates in a DCF valuation, because they’re predicting the future, so the result is also an estimate. If you have bad estimates, the result will be flawed. The discounted cash flow method is still one of the best tools for investors to determine an investment’s total value.

How is discounted cash flow different?

Investors can also use the Internal Rate of Return formula and Net Present Value or other metrics such as cash flowcash on return, or cap rates to determine a property’s potential value.

Discounted cash flow differs from the other valuation methods by allowing investors to determine the value of the projected future cash flow in today’s time. Other metrics, such as Net Present Value, can evaluate the return on the total investment. The IRR formula uses the discounted cash flow to determine a real estate investment’s up or downside.

While not perfect, using a DCF model helps real estate investors evaluate the expected cash flows coming in and out of their property, at a risk-free rate, over the forecasted holding period and determine the future value of their cash flow projections. This information helps real estate investors make better investment decisions.